With the Dow Industrials and S&P500 making all time highs, and with the NASDAQ at a 13-year high, investors are right to question whether or not this bull market "still has legs". Perhaps it's not so surprising that Wall Street strategists and fund managers are divided on the outlook. Below, we summarize some thoughts from noteworthy commentators, while adding our own observations.
Keep this fact in mind:
It's the valution of the market that matters. Not the index level. Since 1900, the S&P 500 Index has been within 5% of its prior peak almost half the time.
We're always wondering if the bull market still has legs...
VALUATIONS: What do valuations say about making an investment in US stocks?
BEARISH investors highlight that stocks are expensive versus backward-looking indicators. While "backward-looking" may sound like a poor way to drive a car, it's a conservative means of valuing the market. Let's face it: The past is the only thing that we really know about corporate earnings. Everything else is speculation.
An indicator such as the "Schiller P/E" (above) is one such method. This analysis, begun by legendary investors Benjamin Graham and David Dodd, and refined by Yale economist Robert Schiller, sought to improve on the simplistic and misleading P/E analysis practiced by many investors -- by smoothing out the economic cycle, taking a ten-year average of inflation-adjusted earnings instead of just one year.
Today, the Schiller P/E analysis suggests that the market is overpriced. Detractors of this analysis say that the most recent ten-year period was one of the worst in history. (Depressed earnings during the financial crisis distort the P/E.) This is a valid argument, but even with a generous adjustment, the expected returns for the next ten years seem to be subpar versus history.
BULLS, on the other hand, highlight that stocks aren't priced in a vacuum, but are actually viewed relative to bonds and other investment classes. Comparing the "earnings yield" (inverse of the P/E ratio) to the yield on US Treasury Notes shows US stocks to be undervalued versus history. Even if one assumes a 2% rise in rates, stocks would still be in the middle of the historic range. (Graph at right. Source: Oppenheimer Funds)
PASSING THROUGH NORMAL: The reader will notice from both graphs that neither indicator is worth a darn when it comes to timing. Stocks pass though "normal" on their way to valuation extremes -- over or undervaluation. When one starts in the undervalued range, long term returns are usually higher.
This point is well made by fund manager John Hussman, a noted identifier of market bubbles and raging skeptic. Since Hussman manages several billion dollars across four mutual funds, he has some credibility in this area. His most recent comments highlight how investors are well served over the long term by being skeptics at later stages of bull markets. His investors aren't always so patient, but he has undeniably built his funds' relative outperformance by waiting patiently for bubblse to pop (as they did in 2000 and 2008). Not all bull markets end with a popping bubble, however...
ARE PROFITS A BUBBLE? Investors are fortunate that the profit margins of US companies have risen to unprecedented heights. Low borrowing costs, energy price declines, and weak labor markets mean that the wind is at the back of US corporate earnings right now. Despite modest revenue growth, earnings have grown by double digits for each of the past three years.
What's the worry, Mr. Hussman?
Investors who extrapolate this profitability into the future will eventually be proven too optimistic (they always get that way), and forward P/E's won't turn out not to have been "cheap" after all. Only in retrospect will investors know that they overpaid.
A concern over collapsing profit margins, though, doesn't seem terribly plausible at this juncture. Low borrowing costs are a product of balance sheet strength. Companies have some of the smallest debt levels in modern history and $1.5 trillion in cash. And those remaining debts have largely been locked in at low rates for the long term. It's no surprise then, that more revenue falls to the bottom line. Secular trends in labor prices aren't set to reverse any time soon, and the American energy renaissance seems to have longer to run. And since profits aren't high because of rampant demand, current profit margins are likely more sustainable.
WARNING SIGNS: Bearish commentators add that investor "bullishness" at 50%+ is near all time highs. "Overbought" momentum signals are blinking red. Margin debt (borrowing money to purchase stocks) is also at historic levels. Long term interest rates, while still low, are indeed rising. These behavioral factors are of great concern to contrarian investors as they indicate the complacency that often occurs at market tops. (The graph at left from Hussman Funds highlights similar periods by dark blue lines.)
One missing piece of a classic bearish pattern, however, is restrictive Federal Reserve monetary policy. And the Fed has indicated their preference for near-zero rates through 2014. Fed Futures don't predict the first tightening until mid-2015.
A SIMPLE ANALYSIS: Jeremy Siegel, Professor of Economics at the Wharton Business School, has been a voice of clarity and simplicity on the stock market for the past thirty years. Prof. Siegel sums things up this way: Different interest rate and inflation environments have warranted different valuations. In low rate, low inflation environments like we have today, stocks have typically sold at 18 - 19 times earnings. The S&P500 is presently around 17x, giving the market room to rise. Or, at least placing stocks within the realm of fair value.
CONCLUSIONS: Our best thinking is that stocks need to consolidate their gains before moving much higher. Some will investors to want to lock in profits before year end. Rebalancing portfolios to earlier target weights makes sense after gains of this size. These are largely short term issues, however.
For the next decade, stocks still look like a better pick than bonds. We just don't expect heroics. First, US stocks will be unlikely to add much P/E expansion to their valuations. (Even Siegel only grants them another few multiple points.) And second, performance will be dependent on earnings growth -- and this is unlikely to persist at the double digit rate of recent years. Compared to the only modest profits likely in the bond market, single-digit stock returns this might be the best that we can hope for.
In this lower return environment, investors shouldn't forget about the role of dividends. Company payout ratios are below historical averages, and strong balance sheets mean that more cash could be returned to shareholders in future years. Predictable cash-based returns will take on greater relative importance, and companies who can consistently grow their dividends should command a P/E premium versus the broader market.
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